Budget Deficits and Current Account Balances

Over the past three decades, the twin deficits hypothesis (TDH) — that budget deficit has a direct effect on current account deficit — has been a topic of interest in the empirical literature (see, for example, Bahmani-Oskooee, 1995; Khalid & Guan, 1999; Mohammadi, 2004; Bagnai, 2006; Salvatore, 2006; Bartolini & Lahiri, 2006; Baharumshah & Lau, 2007; Ito, 2009; Daly & Siddiki, 2009). The causal link between public budget deficit and current account balance has been analyzed extensively in the recent literature, largely because of its implications for long-term economic progress. For small, open economies that depend heavily on foreign capital, an adverse change in foreign investors’ behavior may trigger a series of sharp and disorderly adjustments of external imbalances that, in turn, have serious consequences on the economy (see, for example, Milesi-Ferretti & Razin, 1998; Chinn & Prasad, 2003). In an influential paper, Rodrik (1999) warned: ‘Openness to capital inflows can be especially dangerous if appropriate controls, regulatory apparatus and macroeconomic frameworks are not in place.’ (p. 30).1 From a theoretical viewpoint, fiscal expansion could worsen the current account balance and the appreciation of the real exchange rate (Salvatore, 2006).2 These imbalances may hinder economic growth and undermine a nation’s wealth creation.